Subject COMMERCE Paper No and Title 02: Managerial

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PAPER No. 2: MANAGERIAL ECONOMICS

MODULE No. 1: OBJECTIVES OF THE FIRM

Subject COMMERCE

Paper No and Title 02: Managerial Economics

Module No and Title 01: Objectives of the firm

Module Tag COM_P2_M1

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TABLE OF CONTENTS

1. Learning Outcomes

2. Introduction

3. Economics and Managerial Decision making

3.1 Managerial Decision-making process

4. Economics of a Business

5. Firm and its Objectives

5.1 Profit Maximization

5.2 Wealth Maximization

5.3 Sales volume maximization

5.4 Market share and Growth

5.5 Survival

5.6 Satisficing

6. Summary

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1. Learning Outcomes

After studying this module, you shall be able to

Know the concept of Managerial Economics, and how economics and managerial

decision making is interrelated.

Learn the reason for existence of firms.

Understand various objectives that a firm seek to achieve.

Evaluate why conflicts exist amongst different objectives

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2. Introduction

This module will explain what managerial economics is and how it deals with deciding

the allocation of firm’s scarce resources among competing uses. The inter-linkage

between economics and managerial decision making will be discussed. The major portion

of the module will be elaborating the concept of a firm and the various goals of a firm.

3. Economics and Managerial Decision Making

On the other hand, Management in business and organizations is defined as the function that

coordinates the efforts of people to accomplish goals and objectives using available resources

efficiently and effectively. The two concepts clearly highlight the significant relationship between

Economics and Managerial decision making, and together they have led to the emergence of the

field of Managerial Economics.

Managerial economics attempts to optimize business decision making, given the firm's objectives

and constraints imposed by scarcity of resources.

To solve the business problems and take decisions is the task of the managerial economists.

Resources with the economy/ firm are scarce; therefore the manager has to come out with optimal

solutions so that the resources can be used efficiently and effectively to accomplish the objectives

of the firm. Limited availability of resources acts as one of the constraints faced by the managers

of the firm, the other constraints are imposed by the general economic, political and legal

framework of an economy, for example, the state of economy, the laws related to production,

taxation framework, import-export policy, monetary and fiscal policy, stability of the

government, competition from the rival firms, market entry and exit barriers etc. Given such

complex constraints, the manager makes business decisions.

Economics, as defined by Lionel Robbins (1932), is a science which studies human

behavior as a relationship between ends and scarce means which have alternative

uses. It is a social science that studies how individuals, governments, firms and

nations make choices on allocating scarce resources to satisfy their unlimited wants.

Thus by its very nature, it requires decision making, decision concerning the optimal

use of scare resources to satisfy unlimited needs and wants.

Managerial economics is the "application of the economic concepts and economic analysis to

the problems of formulating rational managerial decisions". In the words of McGutgan and

Moyer: “Managerial economics is the application of economic theory and methodology to

decision-making problems faced by both public and private institutions”.

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Managerial decision making is a complex process, and requires the managers to make choice

among the alternative courses of actions. And, every choice that a manager makes involves an

opportunity cost, i.e. the cost of an alternative course of action forgone to pursue a certain action.

The various decision areas covered under the gamut of managerial economics are:

Selecting a profitable business area,

Assessment and allocation of funds (Investment decisions),

Choice of product, price and market,

Choice of factors of production,

Risk analysis,

Demand estimation, production decision, etc.

3.1 Managerial Decision-making Process:

Decision making is crucial for successful functioning of a firm. At each stage managers have to

make decisions concerning which product to produce, what price to be charged, in what quantity

should the product be produced, how should the product be distributed in the market, how to

grow the business, etc. Though there is no fix procedure of how managers will decide about the

various issues discussed above, but still decision making process can be generalized and consist

of the following steps:

3.1.1 Establishing the objectives The first step in the decision making process is to establish the objective. A firm may

several objectives; however it is considered that one of the most important objectives of

the firm is profit maximization. The other objectives of the firm may include wealth

maximization, sales maximization etc.

3.1.2 Defining the problem The second step requires the firm to define the problem clearly. This step requires a

thorough analysis of the external and internal environment of the firm to clearly

understand and define the nature of the problem. For example, a firm incurring

continuous losses needs to examine various factors to understand why it is facing loss.

The analysis may require the firm to look at its business strategies, the competition,

customers’ demands, labor-management relations etc.

3.1.3 Identifying the possible/ alternative courses of action After having analyzed the problem, manager looks for the solution. Finding an optimal

solution requires a manager to identify and consider all possible alternative solutions. Say

for instance in the example mentioned above, after understanding the problem that why

firm is incurring loses, may consider 2-alternative courses of actions: One, updating and

installing the latest machinery to produce good quality products and Second, changing its

business strategies to focus more on services offered along with the product. Naturally,

the choice between the alternatives will depend on which of the alternative will bring

larger returns.

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3.1.4 Evaluating the alternative courses of action After narrowing down to the possible courses of actions, manager evaluates these actions

in terms of cost-benefit analysis. The course of action appears to be optimum will be

chosen.

3.1.5 Implementing the action/ decision

The final step is implementation of the decision. Implementation requires constant

monitoring of the actions over the period of time, so that the expected results can

be obtained.

4. Economics of a Business

This concept discusses the economic concepts that are fundamental to understanding many of the

issues faced by business firms. It relates to the key issues that affect the ability of the firm to earn

a desirable rate of return on the investment made by it. These include issues like the economic

perspective on the nature, scale, and organization of the firm; the role of information, competition

and technology; principal-agent theory; contracting and the firm's relationships with customers

and suppliers, etc. In this regard, following are some of the issues fundamental to economics of a

business:

Business must use its resources as efficiently as possible since the resources are limited in

supply and there are costs in acquiring and using them. Business must choose carefully

where it wants to put its resources, as with every decision there is an opportunity cost of

foregoing the alternative course of action.

If business wants to maximize profit and grow with time, it is crucial that the firm must

investing money in new capital, products and ways to produce them. Investment is

crucial for business growth.

Products must be priced competitively, be of good quality, imaginatively designed,

marketed effectively and distributed as efficiently and cheaply as possible if customers

are to demand them.

A business must have long term plans to achieve its objectives. Objectives of firm keep

on changing with time. It is usually said that profit maximization is one of the most

important objective of the firm, however the firm may have alternative objectives like

sales maximization, market growth etc. Thus the objectives and plans to achieve these

objectives must be clearly laid down.

Business must sense and respond to challenges coming from competitors and from the

national and international business environment in which they operate.

Businesses are becoming increasingly global in its nature and thus organizations must

look across national boundaries to secure economic advantage.

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5. Why do firms exist?

It is a microeconomic concept that lays its foundation in neoclassical economics that states that

firms (or corporations) exist and make decisions to maximize profits. Interaction of businesses

takes place with the market and this phenomenon assists in determination of pricing and demand

and then the resources are allocated according to models that look to maximize net profits.

The theory of the firm goes hand in hand with the theory of the consumer, wherein the

consumers’ objective is to maximize their overall utility.

Economic agents act and interact through the market. Producers employ factors of production,

sell products, hire labour, raise funds, etc., all of which is done by virtue of explicit or implicit

contracts. One of carrying out production is to rely on the market for each such transaction. This

method is adopted because producers or businesses feel that the market is the most efficient

mechanism for handling such transactions. It is capable of evaluating the cost (price paid) and the

benefit (the product or return received) in the best possible manner. In theory, markets a so

efficient that there is no cost assumed in the use of markets by businesses. The invisible hand of

the market is supposed to be the organizer. The market is believed to be an organizer of

production ‘par excellence’.

If this were the case then there would be no need to employ factors of production like managers

as employees. If markets are most efficient then logically speaking there is no need for a firm to

exist. This is because a firm is a collection of contracts so designed to carry out economic activity

within the firm.

Firms exist as an alternative system to the market-price mechanism when it is more efficient

to produce in a non-market environment. For example, in a labor market, it might be very

difficult or costly for firms or organizations to engage in production when they have to hire

and fire their workers depending on demand/supply conditions. It might also be costly

for employees to shift companies every day looking for better alternatives. Similarly, it may

be costly for companies to find new suppliers daily. Thus, firms engage in a long-term

contract with their employees or a long-term contract with suppliers to minimize the cost or

maximize the value of property rights

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6. Firm and its Objectives

A business firm is commonly defined as a commercial organization that participates in selling

goods or services to consumers in order to reap profits. It employs productive resources to obtain

products and/or services which are offered in the market with the aim of making a profit.

Conventional theory of firm assumes profit maximization as the sole objective of business firms;

however the firms pursue more than one objective. Some important objectives, other than profit

maximization are:

(a) Maximization of the sales revenue

(b) Maximization of firm’s growth rate

(c) Maximization of Managers utility function

(d) Making satisfactory rate of Profit

(e) Long run Survival of the firm

(f) Entry-prevention and risk-avoidance

Let us discuss in details the various objectives of the firm:

Ronald Coase first expounded his thinking about the firm in a lecture in Dundee in

1932, when he was just 21 years old. He published “The Nature of the Firm” five

years later.

His central insight was that firms exist because going to the market all the time can

impose heavy transaction costs. You need to hire workers, negotiate prices and

enforce contracts, to name but three time-consuming activities. A firm is essentially

a device for creating long-term contracts when short-term contracts are too

bothersome. But if markets are so inefficient, why don't firms go on getting bigger

forever? Mr. Coase also pointed out that these little planned societies impose

transaction costs of their own, which tend to rise as they grow bigger. The proper

balance between hierarchies and markets is constantly recalibrated by the forces of

competition: entrepreneurs may choose to lower transaction costs by forming firms

but giant firms eventually become sluggish and uncompetitive.

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6.1 Profit Maximization:

Profit is defined as the difference between the revenue received by the firm and the cost it incurs.

It is the main aim of all the business firms to maximize its profit. Under this objective, firms

choses to invest in projects which yield larger profits, and drop out unprofitable activities. In

maximizing profits, input-output relationship is critical, and in order to maximize the profit, the

firm shall either minimize the input to achieve a given amount of profit or maximize the output

with a given amount of input. In this sense, profit maximization objective of the firm enhances

productivity and improves the efficiency of the firm. However, in the real world, firms may

pursue other objectives apart from profit maximization.

6.2 Long Run Profit Maximization.

In some cases, firms may sacrifice profits in the short term to increase profits in the long run.

For example, by investing heavily in new capacity, firms may make a loss in the short run,

but enable higher profits in the future. This involves sacrificing consumption in the present in

favor of long run investment. This also involves undertaking capital budgeting or long term

investment decisions by the managers. The economic calculations are different and do not

depend on marginal cost and marginal revenue.

6.3 Wealth Maximization:

The main objective of the firm should be to take decisions that maximize the value of the

company for its owners. Firms usually have separation of ownership and control. People who

own the company (shareholders) often are not involved in the day to day functioning of the firm,

this leads to the subtle conflict between the owners and the managers, as owners want to

maximize their wealth. This problem of separation between owners and managers is referred to as

Principal agent problem. The main financial objective of the firm should be 'the maximization

of shareholder wealth'. Shareholders receive their wealth in the form of dividends and capital

gains, and thus shareholder wealth will be maximized by maximizing the value of dividends and

capital gains received over time.

6.4 Sales maximization:

This objective aims to maximize the volume of sales by selling as many products as possible,

without incurring loss. Firm in such a case produces output so that total revenue generated from

sales sufficiently covers the total costs of production.

Firms often seek to increase their market share – even if it means less profit. This could occur

for various reasons:

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a) Increased market share increases monopoly power and

may enable the firm to put up prices and make more profit in

the long run.

b) Managers prefer to work for bigger companies as it leads to greater prestige and higher

salaries.

c) Increasing market share may force rivals out of business. E.g. supermarkets have lead to

the demise of many local shops. Some firms may actually engage in predatory pricing which

involves making a loss to force a rival out of business.

6.5 Market share and Growth:

Firms also wish to increase their share of a market and grow. Firm growth rises when more profit

is retained by managers for future investment, instead of distributing it to the shareholders in the

form of wealth. This objective is significant for firms operating in markets with a few large

competitors. This is similar to sales maximization and may involve mergers and takeovers.

With this objective, the firm may be willing to make lower levels of profit in order to

increase in size and gain more market share.

6.6 Survival:

Some firms take a short-term view and only aim to survive in the market. Survival is crucial for

new firms and for firms operating in highly competitive markets. It is also become one of the

common objectives when the macro-economy undergoes recession or downturn.

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6.7 Satisficing:

6.8 Social/ Environmental concerns.

6.9. Co-operatives

The term was first used by Herbert Simon in 1957. Satisficing means when firms consider a number of different and competing objectives, without aiming to ‘maximize’ any single one. Managers wish to maintain a minimum level of profit that satisfies the owners and then try to deal with other objectives.

In many firms there is separation of ownership and control. Those who own the company (shareholders) often do not get involved in the day to day running of the company. This is a problem because although the owners may want to maximize profits, the managers have much less incentive to maximize profits because they do not get the same rewards, (share dividends)

Therefore managers may create a minimum level of profit to keep the shareholders happy, but then maximize other objectives, such as enjoying work, getting on with other workers. (E.g. not sacking them) This is the problem of separation between owners and managers.

This ‘principal agent’ problem can be overcome, to some extent, by giving mangers share options and performance related pay although in some industries it is difficult to measure performance.

A firm may incur extra expense to choose products which don’t harm the environment

or products not tested on animals. Alternatively, firms may be concerned about local

community / charitable concerns.

Many companies who have adopted such strategies have been quite successful. This

has encouraged more firms to consider these over objectives, but a cynic may argue

they see it as another opportunity to increase profits rather than a genuine sacrificing

of profits in order to promote other objectives.

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Co-operatives may have completely different objectives to a typical PLC. The basic premise

of running a co-operative to maximize the welfare of all stakeholders – especially workers.

The profit made by the co-operative are shared amongst all members.

7.0 Conflict of Objectives

While there are many objectives that a firm could pursue the choice involves a conflict. To

explain this phenomenon we consider a firm that is could be following different objectives.

You have just seen how an objective to maximize market share may not be compatible with an

objective to maximize profits. Businesses may have multiple objectives, many of which conflict.

Think, for example, how difficult it would be for an oil refinery to both maximize profits and

minimize the effect upon the environment of its production activities. Similarly, maintaining high

product quality while minimizing costs would be extremely difficult.

Imagine if a business was struggling. Its costs were rising, its revenue was falling, and it was

being threatened with closure. It had two objectives, to minimize costs while maintaining a high

quality product. It could survive if it were to reduce the quality of its products, but it would have

to alter its quality objective. It might get away with it in the short term, but its customers would

be bound to notice fairly soon. If they do, the reputation of the business would suffer. Demand for

its products would fall and it could end up in an even worse position than it is in at present.

6. Summary

The module discussed how Managerial Economics relies on application of economic

theory and concepts and helps manager make decisions that are in best interest of the

firm.

The general managerial decision making process was discussed.

Various economic concept and issues that are fundamental to understanding the issues faced

by business firms were explained.

The concept of a firm was described, along with the various goals and objectives a

firm may pursue.

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Subject COMMERCE Paper No and Title 02: Managerial